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Financial Ratios 101
How To Interpret Ratios To Filter Out Any Company?
" Strictly For Fundamental Investors "
A Mega Thread ( 50 + Tweets)
Inspiration - @FI_InvestIndia
How To Interpret Ratios To Filter Out Any Company?
" Strictly For Fundamental Investors "
A Mega Thread ( 50 + Tweets)
Inspiration - @FI_InvestIndia
Financial Ratios are are calculated using numbers taken from a company’s :
balance sheet
profit & loss a/c
cash flow statements.
balance sheetprofit & loss a/ccash flow statements.
I Won't Give The Formulas Because Now A Days You Can Find All The Data In Financial Websites.
Website I use -- @finologyticker
Website I use -- @finologyticker
Liquidity Ratios
Liquidity measurement helps us to check the company’s ability to pay of its immediate loan dues.
Not only loans, company must also clear its other current liabilities like vendor payments, utility bills, tax dues, salaries etc.
Liquidity measurement helps us to check the company’s ability to pay of its immediate loan dues.
Not only loans, company must also clear its other current liabilities like vendor payments, utility bills, tax dues, salaries etc.
1/
Current Ratio
Current ratio is a ratio between company’s current assets and current liability.
The bigger is the ratio the better.
Current Ratio
Current ratio is a ratio between company’s current assets and current liability.
The bigger is the ratio the better.
Why?
Because bigger number indicates that the company has more current assets for every rupee of its current liability.
If current ratio is say 2.5, it means to pay current liability of Rs.1 crore, the company has Rs.2.5 Crore (=1×2.5) of current assets.
Because bigger number indicates that the company has more current assets for every rupee of its current liability.
If current ratio is say 2.5, it means to pay current liability of Rs.1 crore, the company has Rs.2.5 Crore (=1×2.5) of current assets.
2/ Quick Ratio
Quick ratio, also known as the acid-test ratio is a type of liquidity ratio, which measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately.
Quick ratio, also known as the acid-test ratio is a type of liquidity ratio, which measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately.
quick ratio above 1 is a healthy liquidity metric.
3/ Cash Ratio
This is the most confirmed metric of liquidity check of a company.
This is the most confirmed metric of liquidity check of a company.
Why?
Because it considers only cash and cash equivalents to check on company’s liquidity.
Examples of cash equivalents can be deposits, T-bills, liquid funds, short term Government bonds etc.
Because it considers only cash and cash equivalents to check on company’s liquidity.
Examples of cash equivalents can be deposits, T-bills, liquid funds, short term Government bonds etc.
For a company, if cash ratio is more than one, we can surely assume that the company’s liquidity is very sound.
It is the ultimate test.
Not many company can claim to enjoy the luxury of cash ratio being more than one.
It is the ultimate test.
Not many company can claim to enjoy the luxury of cash ratio being more than one.
Solvency Check
It is a measure of company’s ability to pay-off all its debts (both long term and short term debts).
Why it is important?
Because if a company is not paying its loan dues, it will be ultimately forced to get bankrupt. So in order for a company not to reach such a situation, it must perform its due diligence on its solvency position.
Because if a company is not paying its loan dues, it will be ultimately forced to get bankrupt. So in order for a company not to reach such a situation, it must perform its due diligence on its solvency position.
4/ Debt To Equity Ratio
Debt to equity ratio helps us in analysing the financing strategy of a company.
The ratio helps us to know if the company is using equity financing or debt financing to run its operations.
Debt to equity ratio helps us in analysing the financing strategy of a company.
The ratio helps us to know if the company is using equity financing or debt financing to run its operations.
High DE ratio:
A high DE ratio is a sign of high risk.
It means that the company is using more borrowing to finance its operations because the company lacks in finances.
In other words, it means that it is engaging in debt financing as its own finances run under deficit.
A high DE ratio is a sign of high risk.
It means that the company is using more borrowing to finance its operations because the company lacks in finances.
In other words, it means that it is engaging in debt financing as its own finances run under deficit.
Low DE ratio:
This means that the company’s shareholder’s equity is in excess and it does not need to tap its debts to finance its operations and business.
The company has more of owned capital than borrowed capital and this speaks highly of the company.
This means that the company’s shareholder’s equity is in excess and it does not need to tap its debts to finance its operations and business.
The company has more of owned capital than borrowed capital and this speaks highly of the company.
5/
Interest Coverage Ratio
It is a financial metric that comes in handy for ascertaining the number of times a company can pay off its interest with its current earnings before applicable taxes and interests are deducted.
Interest Coverage Ratio
It is a financial metric that comes in handy for ascertaining the number of times a company can pay off its interest with its current earnings before applicable taxes and interests are deducted.
With that being said, let’s take a quick look at these pointers to analyse this financial metric –
A ratio of less than 1 indicates that the firm is struggling to generate enough cash to repay its interest obligations.
A ratio of less than 1 indicates that the firm is struggling to generate enough cash to repay its interest obligations.
A ratio below 1.5 indicates the company may not be able to pay its interest on the debt.
Low ratio signifies a higher debt burden and a greater possibility of default or bankruptcy. It also influences a company’s goodwill negatively.
A ratio between 2.5 and 3 indicates that the firm will pay off its accumulated interest on debt with its current earnings.
Operating Performance Ratios --
6/
Operating Cycle
Operating cycle is expressed in days.
It indicates the time taken by the company to convert its inventory in sales, and sales into cash.
Operating Cycle
Operating cycle is expressed in days.
It indicates the time taken by the company to convert its inventory in sales, and sales into cash.
This cycle includes the total time taken to effect sales and to collect payments from customers.
The lower is the operating cycle more efficient is the company’s operations.
The lower is the operating cycle more efficient is the company’s operations.
7/
Gross Margin
It provides a profitability check on the company’s ability to generate profit after sales, by considering only direct cost of manufacturing products, or rendering a service.
No other costs including overhead costs are considered to compute gross margin.
Gross Margin
It provides a profitability check on the company’s ability to generate profit after sales, by considering only direct cost of manufacturing products, or rendering a service.
No other costs including overhead costs are considered to compute gross margin.
Generally speaking, gross margin is a characteristic of a sector as a whole.
For example, an auto company will display a very different gross margin as compared to a company in IT space.
For example, an auto company will display a very different gross margin as compared to a company in IT space.
If the company’s gross margin is above the sector average, it is a clear sign of competitive advantage.
When gross margin is falling, it may be due to selling price pressure – indicating stiff competition. It may be also due to increasing cost of operations.
Increasing gross margin trend is what we would like to see in a company.Again, it is a sign of efficient operations and competitive advantage.
8/
Operating Profit Margin
Operating profit is that money which remains in the hand of the company after considering all operating expenses.
Operating Profit Margin
Operating profit is that money which remains in the hand of the company after considering all operating expenses.
9/
Net Profit Margin
We also refer “net profit margin” as Profit After Tax (PAT) Margin.
Net Profit Margin
We also refer “net profit margin” as Profit After Tax (PAT) Margin.
In its computation “all income” and “all expenses” are considered.
“All expenses” includes, taxes, interest, depreciation, selling & admin expenses, operating expenses etc.
All income means Net Sales + Other income.
“All expenses” includes, taxes, interest, depreciation, selling & admin expenses, operating expenses etc.
All income means Net Sales + Other income.
It is important to note that net profit margin varies from sector to sector.
Companies operating in IT sector will have a higher net profit margin than capital intensive companies like Oil & Gas, Steel, Auto, Cement etc.
Companies operating in IT sector will have a higher net profit margin than capital intensive companies like Oil & Gas, Steel, Auto, Cement etc.
Hence if you want to compare PAT Margin between two companies, preferably do it within its sector.
10/ Return on Equity Ratio
Return on equity ratio can be described as a financial ratio that helps measure a company’s proficiency to generate profits from its shareholders’ investments. ( equity)
Return on equity ratio can be described as a financial ratio that helps measure a company’s proficiency to generate profits from its shareholders’ investments. ( equity)
This profitability helps to gauge a company’s effectiveness when it comes to using equity funding to run its daily operations.
What If The Company has A Lot Of Debt?
Then we have Another Ratio --
Then we have Another Ratio --
11/
Return on Capital Employed (RoCE)
This is one of those profitability ratios that is perhaps the most effective ones of all.
It actually nails the concept of doing business.
It defines how much returns a business is able to yield per unit capital it consumed.
Return on Capital Employed (RoCE)
This is one of those profitability ratios that is perhaps the most effective ones of all.
It actually nails the concept of doing business.
It defines how much returns a business is able to yield per unit capital it consumed.
12/
Price-to-Earnings Ratio
The price-to-earnings ratio, or P/E, is probably the most famous financial ratio in the world.
It's a quick and easy way to determine how cheap or expensive the stock is compared with its peers.
Price-to-Earnings Ratio
The price-to-earnings ratio, or P/E, is probably the most famous financial ratio in the world.
It's a quick and easy way to determine how cheap or expensive the stock is compared with its peers.
The simplest definition of the P/E is the amount of money the market is willing to pay for every $1 in earnings a company generates.
You have to consider whether that is too high, a bargain, or somewhere in between.
You have to consider whether that is too high, a bargain, or somewhere in between.
13/
PEG Ratio
The PEG ratio goes one step further than the P/E.
It factors in the projected rate of earnings growth for a company and may be a better indicator of whether a stock is cheap or expensive than the simpler ratio based on price alone.
PEG Ratio
The PEG ratio goes one step further than the P/E.
It factors in the projected rate of earnings growth for a company and may be a better indicator of whether a stock is cheap or expensive than the simpler ratio based on price alone.
14/
Asset Turnover Ratio
The asset turnover ratio calculates the revenue generated by each dollar of assets a company owns.
It's a good way of comparing how efficiently a company has been using its assets in relation to its peers.
Asset Turnover Ratio
The asset turnover ratio calculates the revenue generated by each dollar of assets a company owns.
It's a good way of comparing how efficiently a company has been using its assets in relation to its peers.
These are Some Of the Ratios You Can Use To Filter Out Companies.
But Remember, The First Step Is To :
Understand The Business Model Of the Company and How it Operates.
But Remember, The First Step Is To :
Understand The Business Model Of the Company and How it Operates.
Otherwise All Other Parameters are Irrelevant.
Read :
Annual Reports
Financial Statements
Companies Conference Calls
Read :
Annual Reports Financial StatementsCompanies Conference Calls
At Last Remember
Check The Valuations Before Investing in A Company.
Check The Management Of the Company.
Check The Valuations Before Investing in A Company. Check The Management Of the Company.
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